A deferred payment situation occurs when the seller delivers goods and services, but then time passes before the customer pays for them. A "fly now, pay later" plan is an example of this situation, as are the so-called "0% financing" plans that some auto dealers use as customer incentives.
By contrast, the prepayment situation occurs when a buyer pays first and then a significant time passes before the seller delivers delivery of goods and services. Tenants typically pay floor space rental fees, for instance, at or before each occupancy period. Insurance companies typically require premium payment before the coverage period starts. Rental expense and insurance premiums paid this way are thus prepayment situations for the buyer.
Explaining Deferred Payment and Prepayment in Context
Sections below further define and explain deferred payment and prepayment in context with related terms from accrual accounting, including the following:
- What are deferred payment and prepayment?
- How are deferred payment and prepayment related to other accounting concepts?
- Prepayment: Payment precedes delivery of goods or services.
- Deferred payment: Delivery of goods or services precedes payment.
- Does the deferred payment and prepayment concept exist in cash basis accounting?
Prepayment From the Seller's Viewpoint
- Firstly, the seller recognizes unearned revenues (or deferred revenues) as revenues received for goods and services that have not yet been delivered. At the same time, the seller records unearned revenues as liabilities,
- Secondly, when the seller actually delivers goods or services, the seller replaces the unearned revenue liability by declaring the revenues, now, as earned revenues.
Prepayment From the Buyer's Viewpoint
- The buyer recognizes deferred expenses (or prepaid expenses or deferred charges), when paying for services or goods before delivery. An inventory of postage stamps, bought but not yet used, is a prepaid expense. Or, when a firm pays taxes before the due date, the firm creates a prepaid expense. Prepaid expenses appear on the Balance sheet under Current assets.
- When the seller actually delivers goods or services, the buyer replaces the prepaid expense asset with an ordinary expense transaction.
Deferred Payment From the Seller's Viewpoint
- The seller records accrued revenues (accrued assets, or unrealized revenues). These are revenues the seller earns for delivery of goods and services, before the customer actually pays. The seller may post these revenues in an asset account, such as accounts receivable.
- When the buyer actually pays, the seller credits (reduces) its own accounts receivable account and, at the same time debits (increases) another asset account, cash..
Deferred Payment From the Buyer's Viewpoint:
- The buyer records and posts the sale amount to a liability account, such as accrued expenses. This is for goods and services the buyer has received but not yet paid for. Or, when a firm owes employees salaries or wages for work completed, the employer has an accrued expense. And, interest due for a bank loan can be an accrued expense. In all cases, these accrued expenses first enter the journal as liabilities.
- When the buyer actually pays, the buyer debits (reduces) the liability account and at the same time credits (reduces) an asset account, such as cash.
For any company on a cash basis accounting system, however, the bookkeeping practice is much simpler. In cash basis accounting:
- Expenses are recognized when cash is paid
- Revenues are recognized when cash is received.
Deferred expenses (prepaid expenses, or deferred charges) along with the other prepayment and deferred payment situations described above, are accrual accounting concepts. These concepts simply do not exist in cash basis accounting.